The Next Trillion Barrels

Based on figures put out by the International Energy Agency (IEA), "nontraditional" methods will play a large role in replacing future oil production. Take a look at the charts below, which are based upon IEA statistics and forecasts.

As we have discussed at length in this and other Agora Financial publications, the world’s known oil reserves are depleting inexorably. Most major oil-producing regions of the world are at or near the stage called irreversible decline. Existing reserves, meaning hydrocarbon products still in the ground, are being developed in a progressive sequence, but are not capable of replacing the existing oil reserves over the long haul.

Nontraditional Methods

New methods and technologies for recovering oil, which are generally called enhanced oil recovery (EOR) methods, are also being applied with great potential for a sustained higher process for oil. And other hydrocarbon resources, such as the tar sands of Alberta or the heavy oil of Venezuela, are also coming online, but in volumes that are marginal at best in terms of daily worldwide demand, which is growing. Finally, there are the prospects for new discoveries in frontier areas such as the Arctic and offshore, to include deepwater areas.

Offshore and Deepwater

Let’s take a look at the future of offshore production, and particularly at production in areas known as "deepwater," meaning depths greater than about 1,500 feet by current understanding of the term. People have drilled wells near or over bodies of shallow water for many decades, to include early efforts in the 19th century. But offshore oil exploration and development as we know and understand it today dates back to the 1940s. Back then, people used land-based technology and began a systematic process of applying it to the offshore environment. Despite great efforts, including large-scale developments in the Gulf of Mexico (GOM) and North Sea, as recently as the early 1990s, there were almost no wells in more than about 1,000 feet of water. Anything deeper than that was considered a technological frontier.

But within the past 15 years or so, deepwater has evolved from being a technological frontier to a strategically important component of the world’s oil industry. Due to this history, in relative terms, the deepwater and ultra-deepwater regions of the world are still underexplored and hold considerable potential. Significant deepwater locations include the GOM, the Arctic regions, offshore West Africa, offshore North Africa, offshore South America, the South China Sea and the margins of the Indian Ocean.

In fact, deepwater is driving significant growth in offshore activities, with at least $20 billion already budgeted for identified projects between 2006-2010. While the deepwater effort is moving to remote sites, often far offshore, the existing fields that are closer to shore still require their own forms of capital investment to boost production via new drilling, redrilling old wells, drilling offset wells and installing and applying other forms of production enhancements.

From the exploration standpoint, deepwater fields tend to be few, but in terms of discovery and exploitation, they are extremely productive. In the deepwater trends of the GOM, for example, there are deeply buried turbidite sands that have yielded in excess of 20,000 barrels of oil per day. Hence, these are key targets for the drillers’ bits, and the potential payoff both invites and requires significant concentrations of capital investment.

Subsea Processing

But offshore and deepwater development does not just start with the massive drillships that grind the initial holes in the bottom of the sea. After the wells come in, there will be a long, complex process of making the wells work. This is generally called subsea processing, and includes making the oil and gas flow from the deeply buried rock formations, dealing with issues of pressure maintenance and handling the byproducts such as sand and deep brine water that come up with the oil and gas. Take the high-pressure, high-temperature regime of deep wells in general and now put these problems many thousands of feet below the surface of the sea. The problems are compounded, literally, by orders of magnitude. After dealing with the "production" issues, another requirement is either to bring the oil and gas to the surface of the sea for transport ashore or to pump it via pipeline to some landfall. The traditional offshore methods for doing this used massive platforms that were anchored to the seabed. But in deepwater environments, this is all but impossible. So we have to consider that it will be necessary to expand the subsea franchise. That is, much of what occurs in the future will have to occur at depth, far offshore and deep beneath the waves.

The subsea market is very much on an upward growth path, particularly when looking at the value of delivered systems between 2001-mid-2007 and forecasting deliveries of orders on the books out to 2011. Subsea production is currently occurring in 50 countries worldwide, with a further 10 nations to join this club within the next few years.

Who Are the Players?

Who are the players in all of this? Here is a chart of the principal leaders among the companies that design, build and deliver significant subsea production systems.

The leading U.S.-traded companies in the subsea field that are stand-alone investment plays are FMC Technologies Inc. (FTI: NYSE), Cameron Intl. (CAM: NYSE) and Dril-Quip (DRQ: NYSE). Another highly regarded company in the field, Vetco Gray, was acquired earlier this year by General Electric (GE: NYSE), already a recommendation in our Outstanding Investments Portfolio. One more company that is a player in the subsea equipment business is Aker Kvaerner, which trades on the Oslo, Norway, exchange. Here are some comparative market statistics for the three U.S.-traded plays, plus information on GE, just for comparison.

As you can see, the companies have relatively high price-to-earnings ratios, but at the same time, they have quite impressive growth records. The subsea arena holds much more promise for sustained growth over many more years, as well, and each of these companies holds its own level of investment promise.

And Aker Kvaerner is an interesting story in its own right. It is a Norwegian industrial and energy conglomerate that trades on the Oslo exchange and currently sells for about 148 Norwegian kroner per share. In the offshore arena, Aker cut its teeth developing technology for work in the North Sea, and thus is a world leader in the field. The company is exceedingly well managed and has returned over 300% gains to its investors over the past five years. But for the purposes of this article, the subsea realm is merely a division of Aker’s energy prowess. Looking forward, half of all semisubmersible drilling rigs in the world currently under construction will be equipped with equipment supplied by Aker. Numerous U.S. institutions hold shares in this company.

Healthy Fundamentals

In the subsea realm, the current market fundamentals are extremely healthy for contractors. Profit margins are large and growing. The supply chain for the offshore sector is close to or at full capacity, which leads to a seller’s market in equipment and services. There are severe constraints in fabrication facilities, manpower, equipment and material availability, leading to cost-inflation overall. Any operator that is planning an offshore project, and certainly a deepwater project, needs to order critical equipment early and keep the time between discovery and production as low as possible.

In the subsea equipment field, the trend is for operators to develop long-term relationships with the suppliers named in this report. These relationships will almost certainly last for 15-20 years and more per project. Due to the unique conditions of each deepwater project, not every contractor possesses the abilities necessary to bid on every job, and the proverbial "low-cost bidder" is not necessarily the one being chosen. So in the future, the money will be flowing offshore, and into deepwater.

In our view at Outstanding Investments, the subsea market has nowhere to go but up.

Until we meet again…
Byron W. King

October 9, 2007